Returns on Capital: Dell Responds

Whitney Tilson examines how Dell calculates its return on invested capital (ROIC) and how it differs from the method he used in last week's column. While both methods are defensible, a hybrid of the two is perhaps the most appropriate. And though Dell may be a complex study in calculating ROIC, it always helps to know some of the details in case you ever encounter a trickier case.

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By Whitney Tilson
June 12, 2001

In last week's column, "Questioning Dell's Returns on Capital," I expressed puzzlement regarding Dell's claim, made in its latest earnings release, that it generated an 891% return on invested capital (ROIC) in its most-recent quarter. (My calculations showed ROIC of under 100%.)

Since then, I have spent some time with a spokesman from the company discussing this issue and reviewing the figures that Dell uses to arrive at ROIC, and I believe Dell's method is one of many legitimate ways to calculate ROIC. As I noted last week, ROIC is not a scientific measure and I think that if you asked 10 experts to calculate Dell's ROIC, I bet you'd get 10 different numbers.

But ROIC is an important enough metric that it's worth spending some time on. (See Andrew Chan's column on the topic for a useful primer.) Let's dive into the numbers and examine how Dell's calculations differ from mine, and see if there is a reasonable compromise.

Net operating profit after tax
The numerator of ROIC is net operating profit after tax (NOPAT). Typically, the calculation is done using trailing 12-month figures, which is what I showed last week: (All figures in millions of dollars.)

                   Q2 01  Q3 01  Q4 01  Q1 02  TOTAL
After-tax          $515    573    412    421   1,921
operating income

Dell, however, annualizes the most recent quarter, so its number is $1,683 ($420.7 x 4).

Invested capital
The real difference is in the denominator of ROIC: invested capital. My method was to add debt plus equity, and then subtract all other cash, cash equivalents, and short-term investments, net of 5% of annualized revenues. (Dell uses this 5% assumption for the amount of cash the business requires. One could argue that having a big cash hoard allows Dell to engage in an extended price war, such as the one currently underway, -- and therefore more of it should be treated as "required" rather than "excess" -- but let's go with Dell's assumption for now.)

Dell's method was to take the sum of net fixed assets and net working capital, less cash in excess of 5% of revenue. To understand the difference, let's start with Dell's most recent balance sheet: (All numbers in millions.)

                                             Q1 02


Current Assets:
  Cash & cash equivalents                   $4,886
  Short-term investments                       381  
  Accounts receivable, net                   2,689
  Inventories                                  350
  Other                                        856
Total current assets                         9,162
Property, plant & equipment, net               924
Investments                                  2,667
Goodwill & other, net                          427
Total assets                                13,180

Liabilities & Stockholders' Equity:

Current liabilities:
  Accounts payable                           4,326
  Accrued & other                            2,056
Total current liabilities                    6,382
Long term debt                                 508
Other                                          785
Total liabilities                            7,675
Stockholder's equity                         5,505

Total liabilities & stockholders' equity    13,180

My calculation of invested capital, presented last week, is:

                                             Q1 02

Equity                                      $5,505
+ Debt                                         508
- Cash & equivalents                         4,886
- Short-term investments                       381
+ 5% of annualized revenues                  1,606

-------------------------------------------------- = Invested capital 2,352

Dell's calculation is:

                                             Q1 02

5% of annualized revenues                   $1,606
+ Accounts receivable, net                   2,689
+ Inventories                                  350
+ Other current assets                         856
+ Net fixed assets (PP&E)                      924
- Total current liabilities                  6,382

-------------------------------------------------- = Invested capital 43

Why is there such a big difference (a total of $2,309 million)? It turns out that the two methods differ in their treatment of investments, goodwill, and other long-term liabilities: Add investments of $2,667 million and goodwill of $427 million and subtract other long-term liabilities of $785 million, and you get the $2,309 million.

Let's look first at investments. Dell's method of calculating invested capital effectively treats this as excess cash and thus deducts it from invested capital, whereas my method does not. Which is right? It depends on whether you think these investments are strategic to Dell and help its operations, or whether they can be liquidated and converted into cash without any effect on the company.

I think the latter is probably closer to the truth, so this would lead one to treat most of this as cash. However, given the current state of the venture capital market, the value of these investments may be overstated, so I would argue that treating half of investments as cash and half as invested capital would be a reasonable compromise.

As for goodwill, I agree with Dell that it should be excluded. Finally, as for the "other" line item under long-term liabilities, I don't know what's included here, but I'm inclined to treat it the same as debt and equity, given that it appears alongside these items on the balance sheet.

So, if we apply these adjustments (italicized) to my methodology and Dell's, we arrive at the same figure for invested capital (again, all numbers in millions):

Using my method:

                               Q1 02

Equity                        $5,505
+ Debt                           508
- Cash & equivalents           4,886
- Short-term investments         381
+ 5% of annualized revenues    1,606
- 1/2 of investments           1,333.5
- Goodwill                       427
+ Other long-term investments    785
====================================== = Invested capital 1,376.5

Using Dell's method:

                               Q1 02

5% of annualized revenues     $1,606
+ Accounts receivable, net     2,689
+ Inventories                    350
+ Other current assets           856
+ Net fixed assets (PP&E)        924
- Total current liabilities    6,382
+ 1/2 of investments           1,333.5
-------------------------------------- = Invested capital 1,376.5

A final difference between our methodologies is that I use the average invested capital over the past year -- consistent with using trailing-12-month NOPAT -- which is $2,056 million after making the adjustments noted above. (I'll spare you the calculations.) Thus, ROIC is $1,921 million / $2,056 million, or 93%.

In contrast, Dell uses average invested capital over the past two quarters -- consistent with using NOPAT that is annualized from the most recent quarter -- which is $189 million (unadjusted) or $1,460 million (adjusted -- again, I'll spare you the calculations). Thus, we can see how Dell arrived at ROIC of 891%: It's $1,683 million /$189 million. After adjusting invested capital, ROIC is 115% ($1,683 million / $1,460 million).

Adjusting for the cost of stock options
Regardless of whether you want to use 93% or 115%, Dell's ROIC appears very high. But, as I noted last week, I believe it's overstated due to Dell's liberal use of stock options to compensate its employees. How should one adjust for this?

There's quite a bit of debate on this topic, but I think using the figures presented in Dell's most recent 10-K is reasonable. Under Note 6 of the "Notes to Consolidated Financial Statements" section, Dell estimates that after-tax earnings for FY 01 would have been $434 million lower had the cost of stock options been expensed. Though the figure I use for NOPAT covers Q2 01 to Q1 02, I don't think it would be far off to use the $434 million figure for FY 01 and deduct it from NOPAT of $1,921 million, reducing it to $1,487 million. Consequently, ROIC would drop to a still-high 72% ($1,487 million / $2,056 million) from 93%.

Dell presents an interesting -- and complex -- case study for calculating ROIC. For most companies, complex judgment calls are not required and a simple calculation like the one I used will suffice. But it always helps to know some of the details in case you ever encounter a trickier case.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He did not own shares of Dell at press time. Mr. Tilson appreciates your feedback at To read his previous columns for The Motley Fool and other writings, visit